Do You Know How Rating Agencies Affect Your Investments?


A risk rating is an opinion about the risk and capacity of an issuer of a security to meet its obligation to pay capital and interest on the agreed terms and deadlines. As early as 1919, rating activity ranged from the United States to the sovereign debts of countries such as France, Great Britain, Italy, Japan, and the Republic of China.

Credit rating agencies have been fundamental in the development of capital markets and promoting transparency information and a culture of risk measurement.

In the case of companies that undergo a qualification process, they can increase the flexibility of their financing sources, have greater access to capital markets, reduce their borrowing costs, improve their relationship with suppliers.

The short and long-term ratings represent an evaluation of the probability of default in the payment of both principal and interest. The difference is based on the fact that a short-term rating is assigned to debt with an original maturity of one (1) year or less. A long-term rating refers to debt with maturities greater than one (1) year.

The rating scales are divided into investment grade or non-investment grade. Investment-grade ratings reflect the ability to repay capital and interest promptly, and non-investment-grade ratings suggest the likelihood of default on obligations.

What Are the Types of Risk Analyzed by Rating Agencies?

The concept of country risk refers to the probability that a country, a debt issuer, will be unable to meet its debt payment commitments, in principal and interest, under the agreed terms. In this sense, there are three sources from which the risk of defaulting on an obligation may be derived:

  • Sovereign Risk: The first type of risk is that held by creditors of government securities, it indicates the probability that a sovereign entity will default on its debt payments for economic and financial reasons.
  • Transfer Risk: The transfer risk implies the impossibility of paying the capital, interest, and dividends due to the scarcity of foreign currency that a country has at a given moment, as a consequence of the economic situation in which it finds itself.
  • General Risk: Finally, the specific risk is related to the success or failure of the business sector due to social conflicts, devaluations, or recessions in a country.

What Is a Risk Perspective?

A risk outlook is assigned to the rating of a long-term debt issue, except for structured transactions, and assesses a potential change. The perspective has a long period and incorporates trends or risks with less certain implications for credit quality.

A “perspective” is not necessarily the step before a rating change. The “outlook” may be “positive”, indicating that the rating may be upgraded or maintained; or “negative” which indicates that the rating can be lowered or maintained.

The three main rating agencies are Fitch Ratings, Moody’s, and Standard and Poor’s.

How Is a Rating Assigned on S&P?

Standard & Poor’s assigns credit ratings to countries based on qualitative and quantitative analysis of a range of financial, economic, management, and institutional factors.

 

The existing analytical framework is articulated around eight main components:

  • Institutional framework
  • Economics
  • Financial administration
  • Budget flexibility
  • Budgetary performance
  • Liquidity
  • Level of indebtedness and Contingent liabilities.

Standard & Poor’s analyzes and evaluates each of these eight factors on a five-point numerical scale ranging from ‘1’ (the strongest rating) to ‘5’ (the weakest).

What Is the Country Risk and Why Is It So Important for Bonds?

It is the flagship index of the J.P. Morgan Chase. This specialized investment bank was the creator of the index and from there, various similar indicators were developed around the world.

Country risk is the difference in the rate (always higher) that a country pays for its bonds about the rate paid by the United States Treasury (considered risk-free). In other words, it is the difference between the performance of public security issued by the government of any country and security with similar characteristics issued by the United States Treasury.

This spread (also known as a spread or swap) represents the probability that the government issuing the debt will not meet its obligations, either due to late payment or denial.

The riskier bonds pay a higher interest, therefore the spread of these bonds concerning the US Treasury bonds is higher. Rating agencies use certain political, social, and economic factors to determine a country’s credit rating.

Market Impact

The economic crisis that is experienced in some countries after the pandemic, has put into question the work of the rating agencies and the rigor of their notes.

In this sense, one of the most controversial cases was that of Bernard Madoff, considered one of the biggest scammers of recent decades thanks to his pyramid system, whose company had a triple-A rating from the Standard & Poors agency.

A similar situation was experienced with Lehman Brothers, whose assets also had the highest rating before the company’s bankruptcy. Even though these rating failures have made these agencies lose credibility, they continue to have a great influence on the markets.

China and Japan have been the biggest creditors to the US for some time. The first of them has the largest foreign exchange reserves in the world and a substantial part of them are deposited in US Treasury bonds in the North American currency.

Key points

Rating agencies can change the risk outlook of any asset, and that can create volatility in our investments. For example, in S&P’s latest report, the company has determined the following changes:

  • Emerging market (EM) economies are benefiting from a stronger-than-expected first half of the year, accelerating vaccine launches, and a reduced tolerance for further constraints on economic activity.
  • As a result, we have raised our 2021 real GDP growth forecast for emerging markets (excluding China and India) to 4.8%, from 4.6% previously.
  • We have cut our 2021 growth forecasts for emerging markets in Asia, but have upgraded our forecasts for emerging markets in Europe and Latin America.
  • Risks to our growth outlook are to the downside and include a delayed exit from the pandemic and a bumpy transition from ultra-accommodative recovery-related policies to tighter expansionary policies across the board.

In this report, we can see, for example, that for the next quarter the currencies of emerging countries could have a better price performance. Also, assets from China and India are expected to have a lower value.

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